How To Tell If You Own The Right Dividend Stocks For A Market Meltdown

Each of the "big name" super investors of the late 20th century is associated with certain investment techniques that define his legacy. When you hear Benjamin Graham, you're going to think about "margin of safety." When you think about Thomas Rowe Price, you're going to think about "growth, growth, growth." When you hear John Templeton's name come up, you're going to think about scanning the globe for international investments. Today, I want to talk to you about one of the best lessons courtesy of Baupost investor Seth Klarman.

Wall Street, the financial marketplace where capital is allocated worldwide, is in many ways just a gigantic casino. The recipient of up-front fees on every transaction, Wall Street clearly is more concerned with the volume of activity than its economic utility. Pension and endowment funds responsible for the security and enhancement of long-term retirement, educational, and philanthropic resources employ investment managers who frenetically trade long-term securities on a very short-term basis, each trying to outguess and consequently outperform others doing the same thing. In addition, hundreds of billions of dollars are invested in virtual or complete ignorance of underlying business fundamentals, often using indexing strategies designed to avoid significant underperformance at the cost of assured mediocrity.

Individual and institutional investors alike frequently demonstrate an inability to make long-term investment decisions based on business fundamentals. There are a number of reasons for this: among them the performance pressures faced by institutional investors, the compensation structure of Wall Street, and the frenzied atmosphere of the financial markets. As a result, investors, particularly institutional investors, become enmeshed in a short-term relative-performance derby, whereby temporary price fluctuations become the dominant focus. Relative-performance-oriented investors, already focused on short-term returns, frequently are attracted to the latest market fads as a source of superior relative performance. The temptation of making a fast buck is great, and many investors find it difficult to fight the crowd.

You know how Warren Buffett has come up with hypothetical constructs like pretending that the market will be closed for five years or pretending that you only have a punchcard that will allow you 20 investments over the course of your lifetime? Here is my corollary to that, based on what I have been able to glean from Seth Klarman's writings: Only own companies that you could stand to see fall 50% in value. It is a great way to remove almost 99% of the stocks out there. The reason it can be such a powerful concept is because one of the main ingredients of successful long-term investing is to avoid selling low.

Once you make the avoidance of selling low a high priority, the next question that follows is this: What kind of companies would not spook me if they declined substantially in price? If you limit your assets to companies that pass that test, you will reduce the likelihood of becoming a victim to panic selling (and it is likely that you will own the kinds of companies that are still churning out profits despite the kind of market environment that would drive prices down by such a significant margin).

I wrote an article about General Electric (NYSE:GE) recently, and many asked me whether I recommended buying it now. I can never answer that question directly because I do not know your individual opportunity costs, temperaments and goals. But I can pose one question that can strongly hint at an appropriate answer: If another financial crisis hit and General Electric's earnings fell below $1 per share and the price fell to $10, would you be holding, buying or selling? If the honest answer is "selling," I wouldn't touch it.

This line of thinking explains why Johnson & Johnson (NYSE:JNJ) has become my largest holding. Some folks have steered clear of the distinguished healthcare conglomerate because of its string of recalls the past 3-5 years, and that is understandable. Every investor has that prerogative. But what attracts me to the stock is that, despite this string of recalls, the company has still managed to grow cash flow by 7% each year. When you have a portfolio of 100+ different products collectively achieving a 22.0% return on shareholder equity while generating profits across the globe in dozens of different currencies, you can afford to take a lot of abuse and still turn out all right.

This is why Johnson & Johnson is at the top of my list of companies that I would buy after a 50% dip. If Johnson & Johnson fell to $40 per share and I could buy in with a 12.5% normalized earnings yield and a 6% dividend yield, that would be a dream come true. The point is, Johnson & Johnson is on the short list of companies along with Coca-Cola (NYSE:KO), Procter & Gamble (NYSE:PG), and two dozen others that I can confidently say that I will buy more as the price declines. The key is to build a portfolio of cash-generating assets that you can have the confidence to acquire during a market meltdown. If you want to successfully execute a "buy low, sell high" strategy, then you should only deal in the kind of companies that you can confidently buy when the stock price goes down.

About a year ago, I remember reading the comments on Seeking Alpha after Intel (NASDAQ:INTC) advanced from $20 to $28 per share. Plenty of commenters said something to the effect of, "Boy, I wish I could have locked in some Intel shares at that 4% yield when I had the chance." Well, now that Intel is giving investors that 4% or more yield, those same investors have become skittish because Intel has lagged the performance of the S&P 500 significantly over the past year. It is one thing if you think the business fundamentals of the company have changed. But I suspect most of these new Intel haters are using recent price movements as an indication of intrinsic value, which as Klarman points out, is a value investing no no. Your analysis should hinge on business fundamentals, not what the other market participants have been doing lately.

At the present time, every stock I own passes the "if it fell 50%, I would be a holder or net buyer of the company under that circumstance." Sure, it has cost me some attractive opportunities along the way. I almost bought Hartford Financial (NYSE:HIG) at $16, but I declined because I could not confidently say I could hold the stock or buy more if it fell to $8 per share. Sure, I have missed out on its current run to $25 per share. But I would be setting myself up for long-term failure if I ever bought an asset that I would sell due to rapid depreciation. That is the number one thing I want to avoid, so I structure my investment decisions in advance to avoid putting myself in that position. If you scan your portfolio and honestly assess whether you would buy or hold each security after a 50% price decline, you can put yourself in an enviable position when Mr. Market reveals his "manic depressive" side that Professor Graham warned us about.

Disclosure: I am long GE, PG, JNJ. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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